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Five Things: What Really Caused the Debt Crisis

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To prevent policy mistakes, it is critical to understand what really caused the crisis.

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1) What Really Caused the Debt Crisis

Yesterday I ran across a recent interview with the Financial Times' Gillian Tett which appeared in Newsweek. Tett has a new book out that looks interesting, "Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe."

In the interview, Tett was asked, Once things started to go bad, there were a lot of mistakes made by managers but also by policymakers on both sides of the Atlantic. What, in your mind, were some of the crucial ones?

"One of the biggest policy mistakes was made by the American officials who repeatedly said that the subprime problem was contained and that there was no reason to worry about it at all. That represented a considerable misunderstanding of how the financial system had changed. They failed to calculate the enormous quantity of derivatives written … nobody knew how big they were."

Her response leads to a point I've been trying to make in Five Things with respect to Socionomics and herding behavior. Consider this point: "one of the biggest policy mistakes was made by the American officials who repeatedly said that the subprime problem was contained and that there was no reason to worry about it at all." Well, that's not really a policy mistake so much as an observational mistake. Saying that one believes subprime problems are "well contained," which is what happened, is not the same as implementing policy.

That may seem at first blush like a very minor quibble, but it gets to the heart of why it is so difficult for people to understand what really happened, and more important, why it happened.

CDO's, CDS's, MBS's and the like are not in and of themselves bad things, which is a point Tett makes as well earlier in the interview. The problem lies in trying to understand why those "potentially good" tools of financial engineering went so horribly awry. It is commonly assumed by many in the media that derivatives are impossibly complex, that no one knew what they were buying and selling, that no one really understood what the risks were or how large the risks were and what factors could cause the tools used to model this risk to fail. Certainly, in individual cases, some or all of these statements could be show to be somewhat true anecdotaly. But that still doesn't explain the core of the problem; namely, how it is possible that seemingly no one fully understood what was happening as it was happening.

The answer is much simpler: the propensity for these derivatives to fall into a morass of perversion is directly related to risk appetites and social mood, not something intrinsic to the derivatives themselves. Unfortunately, that's not a very satisfactory answer. Why? Because there's tremendous pressure to be able to conjure up an explanatory framework for why things happened the way they did. And ironically, that pressure is exerted precisely because the real explanation - that we are humans subject to unconscious herding impulses that trend - is so unsatisfactory, which is due to the very thing that makes the real explanation unsatisfactory.

Wherever direction social mood trends, events will soon follow. We like our stories told linearly because that corresponds with how we experience the world. But reality doesn't care for how we prefer our stories to unfold. The debt crisis, the collapse of real estate prices, the embrace, and subsequent rejection, of seemingly complex and highly engineered finance products all emerged from a peak positive trend in social mood.

A positive social mood trend causes businessmen to become more optimistic, causes the public to embrace risk, speculate more, and overestimate the amount of debt they can service and ultimately foments the creation and availability of derivatives that make perfect sense at the time. Only after the social mood trend peaks do derivatives and speculation seem outrageously complex and dangerous.

Ok, so that's what caused the debt crisis, big deal. Why should we care and what should we do now? It is critical from a policy-making standpoint to understand what brought us to this point. If it is really true that dangerous financial engineering tools that went largely misunderstood and, thus, unregulated, were responsible for collapsing the global economy, the fix is quite clear: ban them. However, if it is true that we are simply victims of our own unconscious herding impulses, then what is the proper policy response to that? That's a tough nut to crack, eh? Ironically, it is the shift in social mood that, one) paves the way for the problem, two) lays the foundation for the solution, which, three) will go too far in satiating the negative trend in social mood that seeks to vilify and punish anyone involved in one. Sometimes you just have to laugh. We remain our own worst enemy... because we refuse to recognize who our own worst enemy is.


2) No Green, Shoot!

I'm not a Dow Theorist, but strictly from an economic standpoint it's interesting to see the Dow Jones Industrials overlaid on the Dow Transports. The chart below shows the lagging behavior for the Transports off the March low... not very comforting for those anticipating a more immediate economic recovery.

Dow Industrial Average (white), Dow Transportation Index (orange)
CLICK TO ENLARGE



3) Gold Vending Machines - Just the Kind of Idea That Flies Near Major Peaks

Germans will soon be able to purchase gold through airport and railway vending machines, according to a piece in the Financial Times this morning. The venture by the TG-Gold-Super-Markt company, "aims to build on soaring retail interest in gold purchases" in the wake of a global financial crisis that "has shaken confidence in a range of other investments."
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No positions in stocks mentioned.

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